How Much Should I Save for Retirement?
Do a Google search for this and you’ll get all sorts of different answers. The most common results suggest 15 – 20% of your income. But this recommendation doesn’t take into account:
- Your current investment potential (how much you have saved/invested already)
- How much you spend each year to maintain your desired lifestyle
- What you’re doing with your savings
- When you want to retire
I’m going to give you some simple models you can use to give you a more accurate, personalized picture of your path, as well as alternative options to the traditional “work until you’re 65” model. All you need to do is plug in your savings and expected lifestyle expenses to see when you can retire and how much money you’ll end up with. Or work backwards by setting a retirement goal and see what your savings and lifestyle expenses need to be to meet that goal.
Start by Estimating Current Investment Potential and Annual Spending
Your current investment potential = current investments/cash equivalents
Add up any savings accounts, cash , stocks, bonds, equity in rental properties, etc. Don’t include things like cars, boats, art, or other collectibles, household items, etc. Even though you could potentially sell them for money, they won’t be generating extra income for you each year (and in most cases will depreciate and/or cost you money to maintain). If you do sell them, at that point you can count the cash you keep towards your current investment potential.
Also, if you have any cash/investments that are generating a lower rate of return than the interest rates of any debt you have, sell those investments immediately and use the proceeds to pay off your high interest debt.
If you own the your own home read this (click to expand)For the purposes of simplicity and accuracy, I recommend leaving the equity in your home and mortgage balance out of your investment potential calculations, and including your total annual mortgage payments in the spending calculation for the remaining years of your mortgage. For example, say your house is worth $300,000, you have a remaining mortgage of $200,000, and remaining monthly payments of $1,300 for the next 20 years. Ignore your equity ($100,000) and mortgage balance ($200,000), but when factoring in your annual spending, include $16,800/year ($1,300 x 12) for your current spending through the next 20 years, but then don’t include it in your anticipated spending year 21 and beyond.
The reasoning is that while your property value may increase over time, it won’t generate annual income. Even if it does appreciate, it will likely be at less than the 4 – 7% rates we’re assuming, it often comes with additional expenses in the form of property taxes, and you won’t realize those gains (in terms of cash to invest) until you sell your home and buy a less expensive one. Consider any equity you have an added bonus that will kick in to reduce expenses when you’re done making payments and a gift you can pass on to your kids.
Exceptions would be if you have rental property and receive a 4-7% return on your equity, or plan to sell your home in the very near future and rent, or downsize – then you can use the equity you have in your home/the cash you receive from downsizing in your investment potential calculation.
Spending = everything that flows out of your wallet, bank account, or credit cards EXCEPT money that goes towards savings or investments (i.e. stocks, bonds, etc.).
DO include money spent on car purchases, repairs, collectibles, etc. as these are NOT investments (see above). Don’t include income taxes, but do include any other taxes (i.e. property, sales tax). DO also include debt payments (car payments, student loans, mortgage payments, outstanding credit card debt, etc.) You can exclude debt payments from spending in future years once they are paid off.
The easiest way to figure out your annual spending is to take a look at your annual bank and credit card summaries. Most likely, all of your credit card purchases will count as spending, while some withdrawals from your bank statement may have gone towards savings/investing or paying your credit card balance (spending which is already included on your annual credit card summary). You could also try using free software like mint to help you with this.
Then ask yourself – are you satisfied with your current lifestyle and spending? Do you expect spending to increase (ignoring inflation*) as you get older and potentially earn more? Or have you already read these saving tips and figured out how you could be even happier living a similar lifestyle for less? We’ll use these numbers in the following retirement models for each retirement approach to determine when you can retire or how much you need to save.
What Are You Doing with Your Savings (Investment Potential)?
As you’ll see in the following models, this can have a big impact on how much you need to save and when you can retire. If you’re just stashing cash in a mattress or a savings account earning .02% interest, you’re going to have to work more to save more. And when you stop working, there’s a chance you could run out of money.
On the other hand, if you invest it (i.e. stocks, bonds, real estate), each of your dollars turns into a little green employee that works for you, making you more and more free money each year due to the amazing power of compound interest. For the following models, we’ll use a return rate of 7% during your savings years (average annual return on S&P500, adjusted to account for inflation) and a more conservative 4% return during your retirement years.** Not sure how to invest? See here for a quick and easy guide to get you started.
Which Retirement Approach Suits You Best?
When it comes to retirement, there are three approaches: the traditional approach, the Financial Independence (FI) approach, or the pretirement approach. The common thread is to get to a point where your money earned from your investments will cover your living expenses for the rest of your life. Using a 4% return almost guarantees you’ll never run out of money and will end up with a large sum to pass down to your heirs or donate. In other words, once you have 25 times your expected living expenses saved and invested, you never need to worry about money again.
For each approach, we’ll cover the basics and provide model examples to show what it could look like in terms of how much you need to save each year to support your lifestyle and retirement goals. And if you have time on your side, you’ll also see how easy it can be to make millions of dollars in free money.
I’d encourage you to download the spreadsheet template and plug in your own savings and spending numbers to see when you can retire and how much money you can end up with. Or start with when you want to retire and your expected annual spending and work backwards to figure out how much you need to save.
Instructions to download and customize spreadsheet template (click to expand)Click here to open the Google Sheet. It will open the template in view only mode. To get your own version you can edit, go to File > Make a Copy (you can give it a new name if you’d like) then click OK.
Once you have your own copy, click on the tab along the bottom for the retirement approach you’re interested in, then follow the instructions on that sheet (in the bottom right) to update with your own info.
For each approach, we’ll ignore any potential social security benefits since they probably won’t cover all your living expenses, differ for each individual, and may one day run out of money. Consider any benefits as an added bonus to your more significant investment income.
The Traditional Approach
This involves working most of your life and retiring at the “normal retirement age” of 65 – 70 years old, when social security and Medicare kicks in. This example assumes:
- No prior savings
- Annual savings/investments of $4,950 ages 23 – 65
- Living expenses of $50,000/year in retirement (age 66 and beyond)
- A 90 year lifespan
Total contributions (money you saved and invested): $212,850
Total “free money” (money your investments made for you): $2,370,068
The Financial Independence (FI)/Retire Early (RE) (FIRE) Approach***
This involves working hard, living frugally, and saving a lot of money early in your life to reach the point where your investments cover your living expenses for the rest of your life. This example assumes:
- No prior savings
- Investing $10,000 at age 23, increasing your investment amount by $2,000 more each year (i.e. $12,000 at 24, $14,000 at 25, etc.), until you reach $30,000 at age 33, then investing $30,000/year ages 33 – 40
- Living expenses of $30,000/year in retirement (age 41 and beyond)
- A 90 year lifespan
Total contributions (money you saved and invested): $430,000
Total “free money” (money your investments made for you): $1,877,130
Years of freedom gained: 25+
The Pretirement Approach
This is the path I’ve prepared for myself, as a sort of hybrid between traditional retirement and FIRE that gives you some freedom to explore the world in your earlier years and the ability to still retire comfortably before the “traditional” retirement age while not needing to be as aggressive about saving.
Since most people who reach FI won’t want to stop working anyways, the pretirement approach may make more sense. It involves living somewhat frugally, working hard, and saving somewhat aggressively in your earlier years, taking a couple years off to live your best life, and then working at a job that covers your living expenses before still retiring comfortably earlier than the traditional retirement age. Since you don’t need to worry about getting paid as much, it’s more likely you can find a job you love in an area you’re passionate about. If it pays more and you can save more, even better! Any extra money, you can pass on to your kids or donate to charity. This example assumes:
- No prior savings
- Investing $10,000 at age 23, increasing your investment amount by $2,000 more each year (i.e. $12,000 at 24, $14,000 at 25, etc.), until you reach $22,000 at age 29, then investing $22,000/year ages 29 – 32
- Pretiring for 2 years ages 33 – 34****
- Living expenses of $40,000/year in retirement (age 60 and beyond)
- A 90 year lifespan
Total contributions (money you saved and invested): $178,000
Total “free money” (money your investments made for you): $2,259,406
Years of freedom gained: 8+ (35+ if you find a job you love and don’t count those years)
*Inflation is already accounted for in the 7% and 4% return rates used in the models, so we don’t need to also account for it in when calculating future living expenses. Also, while some expenses (like medical, travel) may increase during retirement, others (like commuting costs, clothing, food with more time to cook, kids as they gain independence, etc.) will decrease.
**Note that this is just a projected model based on average past performance of the stock market. Actual performance each year can and will vary.
***If planning for FI (living off the money from your investments for the rest of your life), another useful approach is to use your savings rate and that alone to determine how many more years you need to work. This approach is extremely simple, but will also be a little more conservative since it assumes a 5% return during your growth years (and that you don’t have anything saved and invested already).
****Since you’ll probably want your living expenses for these couple years to be in safe, near cash assets, I just assumed a one time cash withdrawal for simplicity. In reality, you’ll want to keep most of that cash in a money market or CDs, which will still pay a 1-2% interest (or even keep some of the money for the second year in the stock market longer), netting you a couple extra thousand dollars.
